Daniel Lacalle: Fiat Currency Debasement, Central Banks, and Gold May 21st 2020 Erik: Joining me now is Daniel Lacalle, chief economist at Tressis and author of the new book Freedom or Equality. Daniel has prepared a chart book to accompany today’s interview. You’ll find the download link in your Research Roundup email. If you don’t have a Research Roundup email, just go to our home page at macrovoices.com, look for the red button that says Looking for the Downloads? Daniel, the question that’s on everybody’s mind, okay, coronavirus crisis, it seems like the worst of the first wave is behind us now. So what does that mean for financial markets? Can we expect the V-shaped recovery that a lot of people are hoping for? Or is it more likely to be U-shaped or L-shaped? Or what do we expect? Daniel: Thank you very much, Erik, and thanks for having me. I think that what we are seeing right now in financial markets is the stage of what I call central bank hope. I think that the idea that we have seen the worst of the coronavirus crisis and that we have embedded in our macro and earnings assumptions are lost to 2020 is driving markets to think of a bottom and expect that the combination of very aggressive monetary policy plus very strong stimulus packages from governments is going to drive to a very rapid level of growth in 2021. My concern is that those two, both the central bank action and government stimuli, are likely to generate more stagnation rather than a strong and healthy recovery. Even if we look, for example, at consensus estimates for 2021, we still see that, in the Eurozone and the United States and most of the developed economies, consensus estimates have gone slightly more bullish about 2021 but very skewed to the latter part of the year. So we’re moving in terms of estimates. We’re moving the improvement to the second quarter of 2021 now, from the previous idea of growth and rapid recovery in the third and fourth quarters of 2020. I also think that the idea from governments that shutting down the economy for a couple of months would have no relevant impact long term on economic growth is out of the picture. Therefore, I believe it is going to be more of a U-shaped recovery: slow, very indebted, with very high levels of unemployment, still very difficult to recover the level of unemployment when the services sector has been hit so badly. But also very difficult to recover the level of consumption we had in 2019, when consumers have had such a tremendous shock that, even if you have not lost your job and you have not lost your salary, it is very unlikely that you’re going to get out of this crisis spending in the same way that we used to do before the crisis. As such, I think that we need to be very prudent. Because, if anything – if we have learned anything from this crisis – is that what we have fundamentally been, even the ones that have been bearish, is too bullish. Erik: Daniel, as you see this recovery, that at least until a week or two ago just seemed like we were charging back, we hit what was just about a 61.8% retracement of the big move down. Was that, in your estimation, likely to have been the top of the bear market rally? Or could it be that we’re going to go up and test new all-time highs again before the market realizes that, hey, central banks can’t solve all problems with printed money? Daniel: In my opinion, that generated the top of a bear market rally, fundamentally because it was driven by the sectors that are more likely to be incentivized or perpetuated by the central bank action via very low rates and higher liquidity. Interestingly enough, this bear market rally has seen the opposite of what we saw in the bull market, which we saw the growth stocks go higher and value stocks underperforming. This has been almost the opposite. It starts to tell me that it’s more about investors looking to position themselves in a way in which they can prudently look for some level of hope without being happy about the likelihood of a rapid recovery. So I think that we can see another leg down, once we have discounted the majority of the stimulus, both fiscally and monetary, but also once we start to see things that are still yet to happen, like competitive devaluations in the case of emerging economies. And another important thing that I think is likely to come out of this crisis, which is an increase in protectionism and probably – I wouldn’t say the same as a trade war, but more protectionist measures. Erik: I was interested to see that Stan Druckenmiller commented at a presentation, or I guess it was on online webinar for the New York Economic Club, saying that this coronavirus crisis just might be the event that finally pops the credit bubble that has been driven by central banks. And I was frustrated that they didn’t really ask him to elaborate on why he thought that this event might have that outcome. Do you think that that’s potentially in play? Are we maybe at the point where central bank largesse has gone as far as it can go and we’re going to have a kind of a realization that it can’t go on forever? Daniel: I would not agree with that assessment. I think that, unfortunately, what we are seeing from the Federal Reserve, the European Central Bank, the Bank of England, is actually that they are exactly following the path of the Bank of Japan. And if that tells us anything, it’s that it leads to stagnation and very high debt. But, certainly, it can last for a very long time. Think about it from a monetary perspective globally. What the Fed in particular, but also the European Central Bank, is doing, those currencies that can be deemed, at least to a certain extent, as world reserve currencies, what they’re actually doing is sucking up the savings of the rest of the world. That can go on for a very, very long time, as long as the weakness of the emerging market currencies remains. And also as long as there is a certain level of nominal growth. So that’s why I think that the recovery is likely to be extremely indebted, Because central banks can continue to disguise risk the way that they have been doing, they might not be able to keep spreads where they left them in 2019. And I’m thinking particularly about some countries in the Eurozone. It’s very difficult for the ECB to continue to leave the spreads between Italy and Germany as tight as they were last year. But it looks to me like what central banks are doing is to incentivize the Japanese solution, which is to zombify the economy, leave things as indebted as possible, and almost bail out the unproductive at any cost. Erik: I agree with you that all indications seem to be that central banks will continue to bail out everybody with as much printed money as necessary. And I agree with you that that eventually leads to probably a deepened, perhaps even intractable condition of financial stagnation. Does this create the backdrop to get us out of secular deflation and into secular inflation? Particularly if we see programs that are more oriented toward delivering money into the real economy, say universal basic income and other kinds of things that give money to Main Street as opposed to Wall Street? Daniel: The risk of what central banks are doing, in my opinion, is that it starts with a deflationary spiral. That deflationary spiral comes fundamentally from the fact that the productive capacity has not disappeared. And what the stimulus is incentivizing goes directly to the sectors that already had over-capacity. So those sectors will try to export their way out of the problem at the beginning of the recovery. That is deflationary. We are seeing it, for example, in China, where industrial production is coming back quickly without really having the customer base open. That, obviously will probably generate a deflationary spiral at the very beginning. Now, where I’m concerned, is the point that you were making, is that, as governments continue to push for inflationary measures, they actually do achieve a level of inflation once the economy starts opening up. Because, on one side, some supply chains have been permanently – not permanently, but at least long-term – damaged. And, on the other hand, you have the debasement of the purchasing power of the currency through all of those programs that you were mentioning. And the risk of stagflation starts to come up. That is the real problem to me. Because central banks and governments, to a certain extent, have a rule book of how to address deflation and how to address inflation. But stagflation is very, very challenging for them. Because, on one side, they will continue to try to push for incentives to a demand that doesn’t come because real salaries are not going up because the productive capacity remains in excess over capacity in some sectors. All of those factors, plus the fact that a lot of that money creation goes directly to financing current spending, which is also deflationary.